The 3 Biggest 401(k) Mistakes
By Amanda B. Kish, CFA
September 10, 2008

News flash: Investors hate to lose money.

While “don’t lose money” is a good rule of investing (Warren Buffett counts it as Rule No. 1), people have been known to make some pretty dumb moves to avoid racking up losses in the stock market — especially in their 401(k)s.

Because 401(k)s are focused on retirement, it’s easy to panic when your portfolio starts to see a downturn. Here are three all-too-common mistakes investors make that can end up hurting you.

1. Chasing performance
When choosing funds for your retirement plan, recent rankings can seem like a safe bet — but focusing on short-term performance can be the kiss of death for your retirement nest egg. Short-term trends can come and go, but long-term performance is much more indicative of a manager’s true abilities.

It’s also easy to put your money in the hottest sector — forgetting that if you wait for a sector of the market to run up before you get in, you’ve probably already missed much of the upside. Chasing hot recent performance is akin to buying high and selling low — a losing prescription if ever there were one.

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2. Trying to play it safe
Watching your investments lose money, especially when it comes to retirement savings, can spur you into “playing it safe” with money market funds and low-yielding bond funds.

But the truth is that nobody ever built a retirement nest egg by investing in money market funds — because they rarely outperform even the annual interest rate, much less the S&P 500. If long-term growth is your goal, stocks or stock mutual funds should be your investment of choice.

Even investors who have retirement in their immediate sights — and who are even more inclined to play it safe — will still need to grow their portfolio for another 20, 30, or more years. Make sure you have enough equity exposure to help your portfolio go the distance.

3. Picking bad, and costly, investments
Unfortunately, not all 401(k)s are created equal. Many contain funds that are expensive, poorly performing, or both — and it means some participants can end up throwing away more than 2% of their assets every year in management fees and expenses.

But as long as your company provides a match — and you’re contributing enough to take advantage of it — even mediocre 401(k) choices are better than not participating. You can always invest in an index fund with minimal fees or ask your plan administrator to provide better funds.

Among the choices you have, however, look for high-performing, long-term managers and a low fee structure — both will keep more money in your portfolio and help you create strong long-term returns.

The Foolish bottom line
No one likes to lose money, so make sure you’re not shooting yourself in the foot by making unwise moves in an attempt to avoid losses. Invest for the long run and stick with good managers, and your 401(k) will help you create the retirement you want to enjoy.

If you’re not sure how to find the best fund managers, check out the Fool’s Champion Funds investment service.

The amounts deferred under your 401(k) plan are reported on your Form W-2, Wage and Tax Statement. Although elective deferrals are not treated as current income for federal income tax purposes, they are included as wages subject to social security (FICA), Medicare, and federal unemployment taxes (FUTA). Refer to Publication 525, Taxable and Nontaxable Income, for more information about elective deferrals. Refer to the Form W-2 Instructions for more information on how amounts should be reported.

401(k) plans are permitted to allow you to designate some or all of your elective deferrals as “Roth elective deferrals” that are generally subject to taxation under the rules applicable to Roth IRAs. The information contained in this guide does not pertain to Roth 401(k)s unless specifically stated.

Two of the advantages of participating in a 401(k) plan are:

• Elective deferrals to the plan and investment gains are not subject to federal income taxes until distributed from the plan.
• Elective deferrals are always 100% vested.

To qualify for the tax benefits available to qualified plans, a plan must both contain language that meets certain requirements (qualification rules) of the tax law and be operated in accordance with the plan’s provisions. The following is a brief overview of important qualification rules. It is not intended to be all-inclusive.

There are several types of 401(k) plans available to employers – traditional 401(k) plans, safe harbor 401(k) plans and SIMPLE 401(k) plans. Different rules apply to each. It is important that you become familiar with your plan so that you understand the special rules that apply to you. Information about the plan must be provided to eligible employees (i.e., employees eligible to participate in the plan) in the Summary Plan Description. An eligible employee may also submit a request in writing to the plan administrator for a copy of the plan document. The administrator may charge a reasonable fee for the copy.

Traditional 401(k) plans. A traditional 401(k) plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested. Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.

Safe harbor 401(k) plans. A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. The safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans.

Employers sponsoring safe harbor 401(k) plans must satisfy certain employee notice requirements. The notice requirements are satisfied if the employer provides each eligible employee with written notice of the employee’s rights and obligations under the plan and the notice satisfies content and timing requirements.

In order to satisfy the content requirement, the notice must describe the safe harbor method used, how eligible employees make elections, any other plans involved, etc.

The timing requirement requires that the employer must provide notice within a reasonable period before each plan year. This requirement is deemed to be satisfied if the notice is provided to each eligible employee at least 30 days and not more than 90 days before the beginning of each plan year. There are special rules for employees who become eligible after the 90th day.

Both the traditional and safe harbor plans are for employers of any size and can be combined with other retirement plans.

SIMPLE 401(k) plans. The SIMPLE 401(k) plan was created so that small businesses could have an effective, cost-efficient way to offer retirement benefits to their employees. A SIMPLE 401(k) plan is not subject to the annual nondiscrimination tests that apply to traditional 401(k) plans. As with a safe harbor 401(k) plan, the employer is required to make employer contributions that are fully vested. This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. Employees who are eligible to participate in a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.

For more information on traditional, safe harbor and SIMPLE 401(k) plans, see Publication 4222, 401(k) Plans for Small Businesses.

Restriction on conditions of participation. Any 401(k) plan cannot require, as a condition of participation, that an employee complete more than 1 year of service.

Automatic enrollment in a 401(k) plan. A 401(k) plan can have an automatic enrollment feature. This feature permits the employer to automatically reduce your wages by a fixed percentage or amount and contribute that amount to the 401(k) plan unless you have affirmatively chosen not to have your wages reduced or have chosen to have your wages reduced by a different percentage. These contributions qualify as elective deferrals. This has been an effective way for many employers to increase participation in their 401(k) plans.

Elective deferral limits. The law, under IRC section 402(g), limits the amount that you can defer on a pre-tax basis each year. A discussion of those limitations is included.

Elective deferrals that exceed the section 402(g) dollar limit for a year or are recharacterized as after-tax contributions as part of a correction of the Actual Deferral Percentage (nondiscrimination) test are included in your taxable income.

Matching contributions. If the plan document permits, the employer can make matching contributions for an employee who contributes elective deferrals to the 401(k) plan. For example, a 401(k) plan might provide that the employer will contribute 50 cents for each dollar that participating employees choose to defer under the plan.  As mentioned earlier, employer matching contributions may be subject to annual tests to determine if specific nondiscrimination requirements are met.

Other employer contributions. If the plan document permits, the employer can make additional contributions (other than matching contributions) for participants, including participants who choose not to contribute elective deferrals to the 401(k) plan. If the 401(k) plan is top-heavy, the employer may be required to make minimum contributions on behalf of certain employees. In general, a plan is top-heavy if the account balances of key employees exceed 60% of the account balances of all employees.

Employee compensation limit. In 2007, no more than $225,000 of an employee’s compensation can be taken into account when figuring contributions. This limit is $230,000 for 2008 and is indexed for inflation.

Plan investment fees. In some cases, plan participants may be liable for investment fees. You can find out more about these fees by visiting the U.S. Department of Labor – Employee Benefits Security Agency (EBSA) web site. EBSA was formerly known as the Pension Welfare Benefits Administration.

Vesting requirements. You must be fully (100%) vested in your elective deferrals. A plan may require completion of a specific number of years of service for vesting in other employer or matching contributions. For example, a plan may require that the employee complete 2 years of service for a 20% vested interest in employer contributions and additional years of service for increases in the vested percentage.

Distributions. General rules relating to distributions are available.

Review your Summary Plan Description or plan document to learn how to apply for a distribution from your 401(k) plan. Your employer or the plan administrator can assist you with the steps that are necessary for you to receive your distribution.

For more information about the treatment of retirement plan distributions, refer to Publication 575, Pension and Annuity Income.